The United States tax code can be a bear to understand. There are a lot of misconceptions about how we are taxed, so we’ll tackle four of the more commonly held misinformed beliefs in this article.
Higher Tax Brackets Do Not Mean ALL Your Income is Taxed at a Higher Rate
The United States has a progressive income tax system. This creates a lot of confusion about what it actually means to “move up” into a higher tax bracket. It’s a common misconception that as soon as you make one dollar over a certain tax bracket your entire income will then be taxed at that higher percentage. Of course, this isn’t true. If it were, a married couple making $75,900 (where they’re highest tax rate is 15%) would take home far more money than if they made $75,901 (highest tax rate is 25%). When you “move up” a tax bracket, you only pay the increased rate for the money in that bracket. In the prior example, the married couple would pay a higher tax only on the $1.00 over the 15% tax bracket. Let’s take a look at the federal income tax bracket for a married couple in 2017:
|Rate||Income Brackets||Taxes Owed|
|10%||$0 to $9,325||10% of taxable income|
|15%||$9,325 to $37,950||$932.50 plus 15% of the excess over $9325|
|25%||$37,950 to $91,900||$5,226.25 plus 25% of the excess over $37,950|
|28%||$91,900 to $191,650||$18,713.75 plus 28% of the excess over $91,900|
|33%||$191,650 to $416,700||$46,643.75 plus 33% of the excess over $191,650|
|35%||$416,700 to $418,400||$120,910.25 plus 35% of the excess over $416,700|
|36%||$418,400+||$121,505.25 plus 39.6% of the excess over $418,400|
Let’s use a single person making $91,900 as an example to see how the progressive tax system works. Again, the misconception is that if you make one dollar more than $91,900, your entire income is then taxed at 33%. Married couples often apply this flawed logic to explain why one spouse doesn’t work. They assume that if the other spouse works, they’ll just be pushed into a higher tax bracket, rendering any gain in income swallows up by the increased tax rate. But that’s not how it works. In this example, if you received a raise to $100,000, you will pay $18,713.75 plus 28% of the difference between $100,000 and $91,900.
So if we put our math caps on, you’ll pay $18,713.75 + [($100,000 – $91,900) x .28] in taxes. Breaking those numbers in brackets down equals $18,713.75 + $2,268 = $20,981.75. To put that number in perspective, taxes owed on $91,900 would be $18,713.75. So you’ll only owe an additional $2,268 in taxes from a raise to $100,000. If your raise to $100,000 were taxed according to the misconception, making $100,000 would result in taking home less money than making $91,900.
Money Put Into Your 401(k) or Traditional IRS Is Not Tax Free; It’s Taxed When You Retire and Withdraw
Setting aside part of your paycheck to put into your 401(k) is a great idea, and I advise most people to do it. This is especially true if your employer matches a percentage of your 401k contribution. That’s free money! But investing money this year into your 401(k) does not mean that money is tax free forever. You see, money invested in a 401(k) is defined as Tax-Deferred Earnings. If you invest $5,000 in a 401(k) this year, it will reduce your taxable income by that amount. For a real-world example, if you make $60,000 and contribute $5,000 to your 401(k), your new taxable income is now $55,000. So contributing to your 401k will reduce your taxes owed this year by $1,250 ($5000 x .25).
So contributing to your 401(k) will save you money in taxes now, but when you draw from your 401(k) at retirement, you’ll pay taxes on it at your normal taxable rate at that time. The hope is that you’ll be in a lower tax bracket when you retire because you won’t need to draw as much income to live.
You Only Pay Taxes on Investment Gains, Not the Entire Investment Amount
This one is a little easier to understand. You’ve invested $50,000 in stocks from a taxable trade account from E-Trade, for example’s sake, and you’ve had a great few years. You’ve made $25,000, so your new E-Trade balance is $75,000 a couple years later. When tax time comes around, a common misconception is that you’ll have to pay taxes on the entire $75,000. But that’s not how it works. You see, it’s called capital gains taxes for a reason, and the only monies you are actually taxed on are the gains you’ve made from your investment. If the current capital gains tax is 15%, you’ll only owe $3,750 in capital gains taxes from your $25,000 in investment income, not 25% of the entire $75,000 in your account.
Another misconception is that you’ll pay taxes every year based on the value of your investments on December 31 of the prior year. That’s not true either. Using the example of stocks as the investment medium, you’ll only pay taxes on the stocks when you sell those stocks for a gain.
As a little bonus tip, any stocks sold for a gain that you’ve held for less than a year are taxed at your normal income tax rate rather than the capital gains rate of 15% if your income falls in the 25% tax bracket or higher or only 5% if your income is in the 15% tax bracket or lower.
Getting a Big Tax Refund Is Not Good Financial Planning
People love getting big tax refunds. In fact, one of the busiest seasons for bankruptcy attorneys is tax season because people will use their refunds to pay a bankruptcy attorney to discharge their debts. But when you receive a big tax refund from the IRS, they are just sending money back to you that you overpaid them throughout the year. When you receive a big tax refund, you’re just using the IRS as a forced savings account that you can only withdraw from one time per year. If you get a $4,000 refund, that means you diverted $333.33 of your income per month to the IRS that you could have used throughout the year. You’ve given the IRS a 0% interest short-term loan.
Here’s another scenario where overpaying the IRS is a bad idea. If you owe the IRS back taxes or have defaulted on your federal student loans, the government can garnish your tax refund to repay your debt. While you should always repay your debts, it would have been better to have that $333.33 during the year to put toward your monthly debts and save all those late payment penalties and interest on your taxes and student loans.
Under the Affordable Care Act, colloquially known as Obamacare, you are subject to a penalty if you fail to secure health insurance for you and your dependants and don’t fall under one of the exemptions to waive that penalty. A little known fact about that penalty is that it’s effectively a voluntary penalty. The only way the IRS can collect the penalty is from your tax refund. If you aren’t owed a tax refund, the IRS can’t force you to pay the penalty, which can be fairly substantial.